Financial Modelling

Read carefully the case notes overleaf.

Factor models on explaining firm's returns in a credit risk context. Is the usual one-factor model good enough?

Then write a report to the Directors of Good credit which addresses these issues.

Factor models on explaining firm's returns in credit risk

You have recently been appointed as an analyst within PMC Inc. PMC is a UK consultancy company that undertakes independent research for client organisations.

Your first client is a building society (Good credit) which provides loans and financial services to both individuals and companies.

Since the 2008 credit crisis that Good credit has been under pressure from the shareholders to implement its own internal risk management models in line with Basel II and Basel III. In credit risk management the most common approach to this problem is to use a firm value model combined with a factor model for the firm's returns.

Traditionally, in firm value credit risk models, a single-factor model is used to model the firm's returns. This factor is typically the market return. The directors of Good credit are questioning not only the use of a factor model but also the use of a single unique factor to model firm's returns. Is a factor model appropriate? How many factors should be used? Is the usual market return single-factor model appropriate?

You have been asked to undertake some quantitative analysis looking at this issue. While you are familiar with statistics and several statistical packages you have not undertaken a project of this nature before. Hence you start by conducting a literature search.

This search proves beneficial and you find that there are a number of existing studies which look at factor models for firm's returns. The best known studies estimate firm's returns from market data and firm's characteristics. Good credit has a particular portfolio of client firms hence your study might reveal different conclusions.

In previous empirical studies a number of factors have been identified as possible determinants of the firm returns in this context, the most common being: market return, firm region, industry sector, firm size, and price-to-book ratio.

From the material you have identified you draw up a list of variables which could influence a firm's return. You then collect numerical data on each of these variables for the market and  for a set of 200 firms randomly chosen from Good credit's portfolio.

You now need to consider how you will analyse this information. In addition you need to consider how you will explain the approach(es) you have adopted and the implication of your analysis given that the Directors of Good credit are not experts in quantitative or statistical methods.

Important points to note:

• You are required to provide explanation and discussion.
• Do not produce graphs if you cannot provide related discussion.
• Do not produce tables if you cannot provide related discussion.
• Do not cut and paste Excel, SPSS, etc. tables into your report. Produce your own summary tables in the main body of your report. If you think appropriate you can provide an appendix with the Excel, SPSS, etc. information.